Why Did Ratings Agencies Fail?

The failure of ratings agencies to properly price the risky securities at the heart of the financial crisis has been attributed to conflict of interest (being paid by the issuers of the assets they are rating) and shopping for the best rating (get more than one rating, then only make public the highest one). However, an objection to these explanations is that these incentives have always existed, yet the problems did not emerge until recently. Thus, any explanation relying upon these incentives must explain why they did not cause problems until recently.

This article says the answer can be found in the complexity of the assets that are being rated. When the assets are very simple, risk assessment is not very complicated and the dispersion of ratings across agencies is very low. Thus, there is no incentive to shop around. In addition, it is hard for the agencies to become beholden to asset issuers and inflate ratings because such behavior would be transparent enough so as to risk losing credibility. That is, people outside the agencies can independently check and verify the ratings easily so any manipulation of the ratings would be easy to discover, and the revelation that their ratings are inflated would damage their credibility and hence their business.

But all of this changes when the assets become more complex. First, because of the complexity the dispersion of ratings across agencies will increase. Thus, even if the mean rating does not change, the variance of the ratings make it worthwhile to pay for more than one rating and cherry pick the best of the lot, i.e. to shop around. (In numerical terms, suppose assets are rated from 1, which is the highest risk category, to 10 which is the safest. A non-complex asset might have a dispersion of, say, 7.95 to 8.05 among a fixed number of ratings agencies, while a complex asset might have ratings running from 6.50 to 9.50. In both cases, assuming a symmetric distribution, the mean is 8, but the rewards to shopping around are quite different).

Second, it is easier for the issuer to capture the rating agency, i.e. for the agency to produce the ratings the company is looking for, because the complexity makes such behavior harder to uncover. The ability of outside observers to uncover such behavior diminishes when the variance of the ratings goes up.

To be more precise about the incentive to shop around, there is a cost to obtaining one more rating, the fee the firm must pay (though the article below implies the firm can escape the fee it if doesn’t like the rating it gets). The benefit is the chance that the new, incremental rating will be higher than the ratings already in hand, and this diminishes as more ratings are collected, i.e. there is a declining marginal benefit. If the fee is relatively low, it will be worthwhile to collect many ratings, and the expected rating outcome – the maximum of the ratings – will be higher as more ratings are collected. However, issuers do not necessarily collect ratings from every ratings firm since the expected benefit of an additional rating may not cover the cost. But if the fees are sufficiently low, if the assets are sufficiently complex, and if the number of firms is sufficiently small – a case that may describe the recent market fairly well – a corner solution will emerge, i.e. it always pays – in expected terms – to collect all the ratings available and then make only the best rating public.

The other side of this, though, is that the degree of distortion falls when the number of ratings agencies is small. That is, the expected maximum rating is increasing in the number of ratings collected (though the increase comes at a decreasing rate, that’s why there is a declining marginal benefit to collecting another rating). It depends upon the nature of the underlying distributions, but it’s possible – and I think likely – that the distortion from this factor was low due to the fact that there were only, effectively, Moody’s and Standard & Poor operating in these markets. If so, if the shopping around distortion is relatively minor because the number of firms is small (and that is highly speculative on my part, and based upon the quick reactions scribbled out above rather than days of careful thought), then the alternative explanation that the ratings agencies were beholden to asset issuers should be given more weight as the likely, predominant explanation for the problems in these markets.

Mark Thoma is a member of the Economics Department at the University of Oregon. He joined the UO faculty in 1987 and served as head of the Economics Department for five years. His research examines the effects that changes in monetary policy have on inflation, output, unemployment, interest rates and other macroeconomic variables with a focus on asymmetries in the response of these variables to policy changes, and on changes in the relationship between policy and the economy over time. He has also conducted research in other areas such as the relationship between the political party in power, and macroeconomic outcomes and using macroeconomic tools to predict transportation flows. He received his doctorate from Washington State University.